Quarterly Market Update – Q4 2021
December Quarter 2021
Market and Asset Class Views
Australian Equities:
The ASX200 posted a new all-time high during the September quarter and recorded eleven consecutive months of gains until the end of August, the first time this has been achieved in 78 years. At its peak, the index had rallied 4.5% as continuing accommodative policy and a solid reporting season augmented with significant distributions to shareholders provided the stimulus. Into quarter end the market corrected to close unchanged on China’s growth slowdown, plus concerns on their indebted property sector raising questions on a possible demand impact for commodities alongside increasing global inflation fears.
The economic outlook for the balance of the year has weakened as the impact of hard-lockdowns in NSW and VIC take their toll. The consensus is for a sharp contraction in activity in 3Q21 as the current Delta Covid-19 outbreak means some restrictions and border closures will likely remain in place until we achieve higher vaccination levels. The latest June quarter GDP release was a surprise beat versus expectations, coming in at +0.7% growth aided by solid household consumption. However, it was the weakest overall pace of expansion in four quarters.
The RBA left interest rates unchanged at historic lows of 0.1% in their September meeting, reiterating their dovish stance of maintaining supportive monetary policy with cash rates unlikely to increase until 2024 when inflation is sustainably in the 2-3% target range. A surprise was the decision to proceed with the tapering of their QE bond purchases (flagged in the August meeting) to $4bil per week from $5bil, which many economists had expected to be delayed given the impending negative Q3 growth data. The RBA’s rationale for this reduction is they expect the current Delta variant outbreak to delay, but not derail, the economic recovery. However, they do expect Q3 GDP to decline materially with the unemployment rate moving higher over the coming months. Economists have slashed their growth forecasts, with most now at around minus 3% growth and one forecaster at -4%. As vaccination rates rise to allow for an economic re-opening into Q4, expectations are for growth to return to circa 1.5%.
An impressive June half reporting season recorded +27% EPS growth, nearly double the 15% expected back in February and an overall beat on consensus estimates. As identified in our previous monthlies, a key outcome was the plethora of cash distributed to investors from record ordinary and special dividends (BHP, RIO, WES), buybacks (ANZ, CBA, NAB, WOW, TLS) plus continuing M&A activity, which is expected to see in excess of $35bil in cash takeovers returned to shareholders. For FY22, EPS growth is currently expected to be circa 12%.
The AUD weakened on the negative Q3 domestic growth outlook and a slowing China economy. Their curbs on domestic steel production saw the iron ore price halve from recent record highs. Despite this, Australia’s August trade balance hit a peak surplus of $12.12bil and the current account at $20.5bil printed its ninth consecutive quarter of surplus, on a record value of commodity exports. We expect a subdued recovery to the mid-70’s over this quarter.
In the final quarter, we may experience more volatility as the market digests the negative GDP number, global growth/inflation pressures and ongoing Covid-19 issues. Nevertheless, we remain confident in risk assets as the economy reopens and policy remains supportive.
We remain Overweight.
US Equities:
US equity markets ended the quarter flat but still saw all three major indices record new all-time highs. An excellent 2Q21 reporting season combined with continued vaccination progress and ongoing strong policy support provided the early catalyst. However, increasing concerns on the economic growth outlook courtesy of the spread of the Covid-19 Delta variant, coupled with ongoing inflation pressures and rising bond yields weighed on sentiment.
The S&P500 index has rallied 100% on a closing basis from its Covid-19 trough of 2,237.40 on March 23, 2020. It took the market 354 trading days to get there, marking the fastest bull market rally off a low since World War II. During the GFC it took the index approximately 2 years to double and on average it takes bull markets more than 1,000 trading days to reach that milestone.
Policy measures continue to remain accommodative with President Biden’s $1bil Infrastructure spending package approved by the Senate. The Federal Reserve (FED) September meeting kept interest rates unchanged in the 0-0.25% range but indicated if the economic progress continues broadly as expected moderation in the pace of asset purchases (QE tapering) may soon be warranted. Strategists perceive this could occur in their next meeting in November. Additionally, half of the Fed board members now expect a possible rate hike in 2022. They reduced their CY21 GDP forecast to 5.9% from 7.0% and increased the core inflation outlook to 3.7% (vs. 3.0%), falling to 2.3% in CY22 as price pressures subside with supply chain factors, goods shortages and unusually high levels of demand returning to pre-pandemic levels.
Similarly, Q3 growth estimates by some economists have been substantially lowered from their earlier expectations, with the impact of the Delta variant delaying maximum employment and higher inflation pressures eroding growth. The latest August payrolls data recorded disappointing jobs growth (lowest since January) as evidence of increasing Covid-19 infections deferred hiring. The market consensus is now around 6% for Q3 versus an actual +6.7% for Q2. For CY21, forecasts sit at ~6.25% growth. Inflation fears have been stoked by comments from both corporates and the FED, with a number of companies highlighting they are still facing ongoing supply chain issues with semiconductor and intermediate goods shortages, combined with shipping delays. Furthermore, Hurricane Ida wreaked havoc on gulf coast crude oil production pushing oil, as well as related product prices up.
An outstanding Q2 earnings season saw EPS growth of +92% YoY for the S&P500, which was the strongest quarterly outcome since 4Q2009 (+109%). Expectations for Q3 earnings are currently +28% and for CY21 estimates have been lifted to +43% from +36% in July. Equity strategists continue to expect further upside for the index, with a year-end target of around 4,700 and to 5,000 by the end of 2022.
We remain Overweight.
European Equities:
The re-opening of European countries during the September quarter pushed European equity indices to new all-time highs. Positive economic data releases combined with a substantial recovery in Q2 corporate earnings saw new peaks for the Stoxx600, Germany DAX and French CAC40, albeit by quarter-end indices across the region closed flat on the period.
Growth across the region rebounded in Q2, with the overall bloc recording +2% GDP QoQ as restrictions were relaxed, vaccination rates improved and household consumption increased. The major European Economic Community (EEC) economies all saw a return to positive quarterly growth, with Germany +1.6%, France +1.1% and Italy +2.7%. Likewise, UK GDP saw a robust 5.5% bounce off the Q1 lockdown induced contraction. Industrial production data into Q3 is positive, despite companies highlighting challenges coming from supply chain issues which is lifting inflation expectations.
The broader region has successfully managed to follow the UK lead and drive a solid increase in vaccination rates, allowing countries to not only reopen domestically but also to permit some controlled inter-country travel during the peak summer tourist season. The EU achieved a 70% full vaccination rate at the end of August, with the UK recording 83% of the 16+ population having received two doses (90% at one dose). This has seen the majority of previous restrictions across the region lowered for service and hospitality industries. In the UK, the so-called “Freedom Day” on July 19th effectively removed all restrictions which saw a spike above 40,000 in daily Covid-19 cases, however, hospital admissions and deaths remain substantially below the peak levels seen last January and in April/May 2020. The UK government has announced a proactive plan into the winter period of booster jabs for the over 50’s and the vulnerable, to alleviate any pressure on the healthcare system.
The ECB retained a supportive monetary policy setting in their latest meeting, keeping interest rates at 0%. However, they will moderate their QE programme into Q4 but were quick to articulate that this was merely a recalibration of the level of purchases from the previous two quarters, not a tapering. The total envelope remains at €1.85tril. Once again they lifted their 2021 GDP estimate to 5% from 4.6%, reflecting the bounce-back across the region. They also lifted their inflation estimate for CY21 to 2.2% vs. 1.9% and for CY22 to 1.7% from 1.5%. The latest August inflation number was +3.0% YoY, the highest since 2011. The IMF have likewise raised their EU growth estimates for this year and next, plus a significant upward revision for UK CY21 GDP to 7.0% from 5.3%. The UK estimate is consistent with the consensus as consumer spending accelerates combined with strong jobs growth, putting the unemployment level at its lowest since July 2020 and job vacancies at an all-time high.
The earnings recovery continued, with Q2 results for the Stoxx600 surging approx. 150% YoY from the depths of the last year’s Covid-19 economic shock. The consensus earnings estimate for CY21 has increased to circa 55% growth (vs. 40% in June) and a PE multiple of 16.0x, still attractive versus global peers. Like elsewhere, M&A activity is strong with multi-billion-dollar deals across numerous sectors including retailing/supermarkets, real estate, semiconductors and aerospace manufacturing.
We remain Overweight.
Emerging Market Equities:
Emerging market equities, as measured by the MSCI Emerging Markets Index, lost 4.36% over the September quarter in AUD terms, underperforming the developed market counterpart. While the growth of Covid-19 infections in most EM countries have slowed down from May-June, the economic recovery of many EM economies lags behind, mainly due to a slower vaccine rollout and limited scope of fiscal stimulus.
Over the quarter, we have seen sudden regulatory landscape changing in China, including crackdowns on internet companies, for-profit education, online gaming and property market excesses. The changes are structural, not transitory. These series of actions are intended to tighten the regulation of consumer-facing platform companies, tackle monopolies, promote ‘common prosperity and ultimately strengthen the government’s centralised power. We expect Beijing’s clampdown on technology and private education companies to continue and expand in years to come. This will reduce corporate profitability and equity valuations for Chinese TMT (Technology, Media and Telecom) companies.
Most EM countries maintain an accommodative monetary policy stance as long as necessary to support the economic recovery and to help mitigate the negative impact of Covid-19. Some countries like China are working on reducing its level of debt at various levels as a way to tackle the anticipated interest rate rise from the US.
Indian economy expands strongly, amid a low base effect from last year and despite the second wave of Covid-19 infections and localised lockdowns. Foreign demand in Taiwan and South Korea is strong, as seen by the positive contribution from trade to GDP. However, Manufacturing PMI decreased amid surging infections and raw material shortages.
Emerging markets are an important part of a well-diversified global equity portfolio and offer many potential benefits. However, recent data reminds us that they can be volatile and can perform differently than developed markets. We remain cautious and move to a negative stance from our neutral setting.
Property:
The performance of A-REITs have been strong over the September quarter, returned +4.2%, outperforming the broader ASX200 by 2.4%. Over the past 12 months, the ASX200 A-REITs Index posted a gain of +29.9% tracking closely to the +30.9% return of the broader market.
Although major capital cities have been in and out of lockdowns, business sentiment has improved significantly so did the Office utilisation rate as shown in the recent CBRE survey.
The reopening plan announced by the states to gradually ease restrictions as we head into the holiday season provide positive news for Retail assets, particularly those with exposure to retailers and the consumer services industry (such as restaurants, gyms and cinemas).
With the help from government stimulus and ultra-low interest rate, the Residential property sector has enjoyed a record year of sales and buyer activities. Monthly housing price growth is below its March peak but is still annualising at around 20%. Nonetheless, we remain cautious in this sector with recent data showing deterioration of lending standards, and RBA indicating that tightening of the lending standard may be in the horizon. We look to hold our slight positive view on A-REITs for the final quarter of 2021, buoyed by strong momentum in the class and also a beneficiary of strong equity market conditions.
Alternatives:
Private Equity
Last quarter we lifted our weighting in private equity to the maximum exposure, with the intention of holding for no less than 12 months. This commitment was made as private equity is a class that is not easily entered and exited due to liquidity constraints and the incubation period for returns typically occur slower than in listed markets.
Private equity has experienced increased activity through the first half of 2021, aided by the continued economic recovery, low-interest rates and dry-powder.
We continue to benefit from the strong tail winds present within the class and retain our positive outlook, whilst highlighting the importance of manager selection particularly their skill in creating value through operational, strategic and sector expertise.
Gold
Gold has proven to be choppy over the previous quarter, trading under $1700/oz an ounce in August and as high as $1826/oz early September, with $1800/oz deemed to be fair value (BCA Research). The lack of trend in real yields for the past year, as well as the stability in inflation expectations over the last six months, suggest that gold could remain range-bound between $1700/oz and $1900/oz for a few more months.
From a portfolio perspective we still retain a neutral position for the precious metal with the view it’s a defensive holding that also offers inflationary protection. This thesis continues to be tested.
Hedge Funds
Hedge funds continue to be a key diversifier and we retain our slight over-weight position heading into the final months of the calendar year. With volatility and market risks emerging we see agile, unconstrained managers well served to bet against major trends and take advantage of market moves.
To be best placed to capture this type of exposure we retain our preference for Global Macro strategies.
Infrastructure
Global Infrastructure, as measured by the S&P Global Infrastructure Index (+22.1% over past 12 months in AUD total return terms) so far has lagged the recovery we have experienced in equity markets since the March 2020 Covid sell-off. However, the increasing speed of the vaccine rollout and the effectiveness in preventing hospitalisations has allowed mobility restrictions to ease globally, which is positive news for many infrastructure assets.
We retain our Neutral exposure to the asset class.
Fixed Income:
We traversed the last quarter underweight Government Bonds and endured some consequent underperformance until very recently. Markets viewed inflationary forces as being transitory and the continued resolve of central banks to keep rates low saw 10-year rates rally to touch 1.10% (Aust) in late August. They have now rebounded to 1.48%. Driving sentiment has been continued strong CPI and PPI data which has re-awakened investors as to the risk of inflation. Central Bank rhetoric has also reflected this as evidenced in the last Fed Fund meeting and subsequent comments from Chair Powell et al.
Powell has been careful in guiding the market that the bond tapering process will be quite separate from interest rate adjustments. The tapering action is to address market liquidity of which there is an (over) abundance and has been distorting asset markets. The latter will be adjusted once unemployment and workforce utilisation are at target with wage inflation being the key to timing and size of moves. We see yield curves continue to steepen, with inflation data driving the pace. With inflation we need to discern whether it is supply-side – which the Fed is disregarding vs. wage driven, which is their key indicator. It is early days yet on the outcome either way we remain at our current Underweight setting.
Looking at the market through the credit lens, we are a little less negative. Most of the market is floating rate in construction, so that is a plus. The exit from the Fed as a buyer of last resort in Investment Grade issues, introduced last March, has been discounted in Investment grade asset pricing. Likewise in Australia, corporate credit is robust and in a TINA world, we will only see minor sell-offs. For sub-prime markets, the spectre of rising rates and reduced excess liquidity is not a current threat. The Evergrande ‘event” has been well flagged in the sub-prime asset market and we believe that the Chinese authorities will not want a “Lehman Bros” type of shock to a sector that is 25% of GDP growth but will manage in the style that the Japanese central authorities did post the 1980’s domestic property credit bubble. The challenge here is are we being too trusting in China’s competence? Domestic higher yield credit remains sought after as the asset class gets newfound appreciation from investors seeking diversification. We retain a modest Underweight in Credit.
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